Despite all the warnings to the contrary, 2023 turned out to be great for investors. A feared recession failed to materialise, even as the Federal Reserve hiked interest rates to their highest level in more than a decade to curb inflation and geopolitical tensions threatened to destabilise the global economy. Stocks and bonds soared, with the Morningstar US Market index up more than 25% for the year and the Morningstar US Core Bond index up nearly 5.5%.

Will 2024 bring more of the same?

John Bellows, a portfolio manager at Western Asset Management, says inflation has gone “from being an acute problem this time last year to now being not a problem”. That’s a very dramatic change, with far-reaching effects on financial markets in the months ahead.

“Portfolio strategies that were very effective during periods of low and stable inflation can again be effective,” he says. Here’s what investors need to know.

Bonds Are Back – For Real This Time

Investors spent much of 2023 bracing for a third straight year of losses in the bond market as yields soared along with interest rates. But as inflation slowed and the market gained confidence about the prospect of Fed rate cuts in 2024, bonds rallied in the fourth quarter.

Treasury Yield and Federal-Funds Rate

Data as of Dec 27, 2023 Source: Federal Reserve Economic Database

Analysts expect that momentum to continue in the new year. Kristy Akullian, iShares senior investment strategist at BlackRock, says this change means investors can now turn their attention to extended-duration investments (bonds with maturities of five to seven years) rather than shorter-term bonds at the front end of the yield curve.

Bellows says an environment with falling interest rates and low inflation means that bonds can once again act as an effective portfolio diversifier. While stocks and bonds have been highly correlated over the past few years (meaning they rise and fall together), he thinks a negative correlation is “likely to reemerge in the environment we’re going into.”

This is important for investors even when risk assets like stocks are doing well. “If something were to happen” in equities markets, Bellows says, like a geopolitical shock or a sharp fall in economic growth, “then you have some valuable diversification in your portfolio”.

Cash Isn’t King

Yields on cash rose sharply over the past two years, meaning investors could earn decent returns on their uninvested holdings. But with rates set to fall (albeit not as low as they were over the past 15 years or so), strategists agree that investors can find better ways to put their cash to work this year. Bellows points out that during periods when inflation has fallen, or when the Fed has reached the end of a hiking cycle and moved to cutting, cash holdings have outperformed other investments only for very short times. Then, he says, cash has “dramatically underperformed over a longer time.”

Now, investors would “do better to lock in [today’s high] yields and then benefit from those falling yields by having a little bit more duration or interest rate risk in your portfolio,” Bellows explains.

Akullian adds that investors shouldn’t wait until the Fed starts cutting rates to add more duration to their portfolios. It could be six months or more before cuts come, even though the bond futures market is expecting them as soon as March. That gives investors plenty of time to benefit from higher yields today. “Get out of cash, but pick your spots,” she advises. “That’s our message for 2024.”

Expect a Broader Rally…

For the better part of 2023, the “Magnificent Seven” mega-cap tech stocks drove the lion’s share of gains in the equities market amid a surge of enthusiasm surrounding artificial intelligence. Analysts say that phenomenon will fade somewhat in 2024.

Magnificent Seven Stock Performance

Source: Morningstar Direct, December 28, 2023

“Our expectation is for the rally to broaden out quite a bit,” Akullian says. While 2023 was the year of the mega-cap tech stock, “2024 can be the year of everything else”.

While Jeff Buchbinder, chief equity strategist at LPL Financial, doesn’t expect Big Tech’s dominance to entirely disappear in 2024, he says he’s “cognisant of a potential market shift towards more things working and a market that’s less reliant on these top seven stocks”.

Akullian points to what she calls the “lovable laggards” as potential breakouts. These are stocks that trailed the rally in 2023 because of high interest rates, but which could be poised for outsize gains in the year ahead as rates fall. Small caps and financial stocks fit the bill. Buchbinder is also keeping an eye on international markets.

…But Don’t Forget About Quality Equities

Excitement over the prospect of rate cuts may be pushing stocks toward a new high, but a slowdown is still very possible in 2024. Lagged effects of the Fed’s tightening cycle may be yet to appear, and many economists expect growth to slow.

Akullian says companies with strong balance sheets and low leverage will help investors weather any potential storm. “We still feel most comfortable on the equity side having a quality core of your portfolio that lets you go out and add risk in other places,” she says.